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    Oct. 10, 2024

How to Apply Alt Data Best Practices to AI Systems

Given recent acceleration of developments in artificial intelligence (AI), regulators and authorities globally have begun to examine the use of AI in various industries, including by investment advisers in connection with trading and investment decisions. Although the SEC has proposed a rule focused on conflicts of interest created by the use of predictive data analytics (PDA), including AI, (PDA Rule), U.S. regulators have yet to provide firm guidance on the application of existing regulations to advisers’ use of AI in connection with trading and investment activities. In the absence of such guidance, advisers should consider adopting AI policies and procedures that focus on insider trading concerns and are consistent with current best practices for alternative data (alt data) use. This guest article by Lowenstein Sandler attorneys Boris Liberman and George Danenhauer describes how advisers’ use of AI has evolved, discusses the applicable regulatory framework and explains how to apply alt data best practices to AI systems. See this two-part series on the SEC’s proposed PDA Rule: “Proposal Background and Overview” (Sep. 14, 2023); and “Issues and Implications for Hedge Fund Managers” (Sep. 28, 2023).

SEC Enforcement Action Reminds Advisers Not to Forget Pre-Employment Political Contributions

The rules on political contributions by investment advisers and their associates to elected officials who make decisions for government entities on advisory services are strict. Neither investment advisers nor certain employees may provide compensated advisory services within two years of a contribution, as per Rule 206(4)‑5 under the Investment Advisers Act of 1940, often called the Pay to Play Rule. No quid pro quo or actual intent to influence an elected official is required to run afoul of this rule. Moreover, the Pay to Play Rule applies to contributions made by designated employees while they are employed by the adviser, as well as to certain pre-employment contributions. An SEC enforcement action against an investment adviser serves as a cautionary tale in this election year that advisers should not forget that pre-employment political contributions may trigger the restrictions of the Pay to Play Rule. This article summarizes the cease-and-desist order entered by the SEC against the adviser on August 19, 2024. See “In an Election Year, Advisers Should Be Particularly Alert for Potential Pay to Play Issues” (Aug. 1, 2024); and “Fund Managers Must Continue to Guard Against Pay to Play Violations” (Oct. 29, 2020).

Morgan Lewis Program Previews Fall 2024 Regulatory Developments

Although legal challenges and the upcoming presidential election have put a damper on rulemaking, federal agencies continue to advance initiatives affecting private fund advisers and other financial services firms – and SEC enforcement activity continues unabated. At a program entitled “Fall 2024 Regulatory Roundup,” attorneys from Morgan Lewis discussed the newly adopted rule requiring investment advisers to implement anti-money laundering programs; SEC enforcement activity against investment advisers and broker-dealers; the new clearing requirement for secondary market transactions in U.S. Treasury securities; CFTC enforcement activity; and NFA rulemaking. This article distills the key takeaways from the program. See “Update on SEC Rulemaking, Examinations and Private Fund Rules” (Aug. 1, 2024).

Enforcement Actions Highlight Advisers’ Duty to Accurately and Honestly Communicate With Investors

When an investor raises a complaint, fund managers often scramble to hastily address and soothe the investor’s concerns. That’s the nature of client relationship management, particularly in today’s ruthlessly competitive fundraising environment. It is important, however, for fund managers to balance being responsive with their fiduciary duty to carefully and accurately describe all matters related to their funds – especially quantitative items such as disputed performance data. The significance of that lesson was emphasized anew by the SEC when the agency released two orders settling cease and desist actions against an investment adviser and one of its principals (together, the Orders) for material misstatements and omissions made in response to queries raised by an institutional investor client. Ultimately, the series of fraudulent responses by the adviser and its representatives caused the institutional investor to inadvertently breach its statutory obligations. Although the fact pattern is unique, the Orders highlight the degree to which the SEC may scrutinize fund managers’ communications with investors generally, as well as the importance of ensuring the accuracy of performance calculations, performance reporting and any other information provided to investors. This article summarizes the key features of the Orders and provides additional insights from industry experts. For more on communicating with investors, see our two-part series “How Are Your Peers Responding to the Most Intrusive Requests From Hedge Fund Investors?”: Part One (Mar. 17, 2016); and Part Two (Mar. 31, 2016).

Adviser Penalized for Undisclosed Conflicts and Principal Transactions

In 2022, the SEC charged the principal of an investment adviser with engaging in “a series of undisclosed and fraudulent conflict-of-interest transactions” with a private fund he managed. Those transactions, many of which the SEC claimed were principal transactions, allegedly benefited the principal at the fund’s expense. He and the SEC have reached a settlement. Although the SEC’s complaint included multiple counts of securities and investment adviser fraud, the final judgment covers only the non-scienter adviser fraud and principal transaction claims – and imposes modest financial sanctions. This article details the SEC’s allegations and the settlement’s terms. See “SEC Imposes Substantial Sanctions for Cross Trades & Principal Transactions, Despite Self-Reporting, Cooperation & Remediation” (Apr. 13, 2023).

Former SEC Enforcement Attorney Joins Thompson Hine

Ernest E. Badway has joined Thompson Hine as a partner in its business litigation and investment management practice groups in New York. Having previously served as an SEC enforcement attorney, he focuses his practice on regulatory enforcement matters, as well as criminal and civil litigation. For more from Badway, see “Federal District Court in New York Rules That ICOs May Be Securities” (Oct. 4, 2018). For more from other Thomson Hine partners, see “Operation and Implications of Nasdaq’s Board Diversity Rule Proposal” (Apr. 1, 2021).

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